Impermanent loss happens for a couple of reasons, the biggest reason is price change. This type of impermanent loss happens when the price of your deposited tokens in the pool changes. The bigger the change, the bigger the loss.
While it may seem strange to consider you can lose tokens by providing liquidity, this is an inherent characteristic of automated market makers. While providing liquidity to a liquidity pool is often profitable, you’ll need to be very mindful of the concept of impermanent loss.
The Sovryn protocol allows any adequately funded user to become a market-maker and earn trading fees. From time-to-time, LPs can earn additional liquidity mining rewards during special promotions. Market making enables a frictionless activity with growth potential within the Sovryn protocol.
Below you will learn everything you need to know about one of the most important concepts when it comes to providing liquidity – impermanent loss.
Impermanent loss happens when the price of your deposited assets in a liquidity pool changes compared to when first deposited. The bigger the change, the more likely you are to experience impermanent loss. This type of loss means your tokens have less value/quantity at the time of withdrawal than they did at the time of deposit.
Assets that remain relatively stable with small small price fluctuations are less subject to impermanent loss. For example, stablecoins stay in a tightly contained price range. So stablecoin pools are significantly less risky when it comes to impermanent loss.
The simple answer is, impermanent loss is often offset by earning trading fees. Thanks to trading fees, even pools with tokens that are quite exposed to impermanent loss can be profitable.
Let's deposit 1 of token “A” and 100 of token “B” in a liquidity pool. First, let's make a few assumptions:
Based on the assumptions above, the total dollar value will be $200 at the time of deposit.
Let's also assume, other LPs have already funded the pool with a total of 10 of token “A” and 1,000 of token “B”. In this case, we currently have a 10% share of the pool, which has total liquidity of 10,000.
If the the price of 1 token “A” increases to the equivalent of 400 token “B”, the ratio between how much token “A” and token “B” there is in the pool has changed. As a result there is now 5 token “A” and 2,000 token “B” in the pool.
If we decide to withdraw our funds, we are still entitled to a 10% share of the pool. As a result, we can now withdraw 0.5 of token “A” and 200 of token “B”, totaling $400. As you can see, we made a decent profit since our initial deposit of $200 worth of tokens, but what if we simply held our 1 token “A” and 100 token “B”? If we simply held the tokens, we would've had a combined total of $500.
We would have been better off holding rather than depositing into the liquidity pool. The $100 difference is the impermanent loss.
Also consider, our example does not take into account the trading fees we would have earned for providing liquidity. Earned fees can negate losses and result in profits. That said, it’s important to fully understand impermanent loss before providing liquidity to a pool.
It is important to understand that impermanent loss happens regardless which direction the price changes. The only thing that matters when it comes to impermanent loss is the price ratio relative to the time of deposit.
Impermanent losses become realized/permanent only when you withdraw your tokens from the pool. Fees you earn may offset the losses.
Be mindful when depositing funds into one of the liquidity pools. As outlined earlier, certain liquidity pools are more subject to impermanent loss than others. As a general rule, the more volatile the assets, the higher your risk of exposure to impermanent loss.
Impermanent loss is a the fundamental concepts that should be fully understood by anyone who wants to provide liquidity to the Sovryn protocol. Keep this key point in mind, if the price of your deposited assets changes, up or down, you will likely be exposed to some degree of impermanent loss.